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Why You Should Strategically Structure Your Portfolio Now?

Apr 28, 2017

The Indian equity market is at an all-time - sailing at 30k on the S&P BSE Sensex.

"Be fearful when others are greedy and greedy when others are fearful," is the famous quote of legendary investor, Warren Buffett.

But is everyone going by these words of wisdom?

Not really.

It's party time on Dalal Street...and champagne is flowing.

Investors are smiling all the way to the bank.

But wake-up dear investors while you may be intoxicated by this exuberance.

It is time that you review your portfolio before the party ends on Dalal Street and the Indian equity market heads downward.

Here are few hard facts...

From a valuation standpoint, the Indian equity market has become clearly overpriced. The trail P/E of the small-cap and mid-cap index is sailing at 72x and 33x respectively, overtly placed in the overpriced territory. Even the large caps and the benchmark S&P trail P/E, is also hovering around 25x and 23x respectively, displaying a low safety margin.

"Buy Low, Sell High" is the ubiquitous investment mantra. But even most experts may be mistaken about the right time to buy or the right time to sell. Therefore, you always invest with some sense of market valuation and market direction.

India's GDP (Gross Domestic Product) data after reporting a 7.0% growth in Q3 of the fiscal year 2016-17 - rebuffing the impact of demonetisation - is expected to trim a bit during the last quarter of the fiscal year 2016-17, as the overall impact of demonetisation becomes evident. In fact when the Q3FY17 data was released, Economic Affairs Secretary, Mr Shaktikanta Das had acknowledged that in the absence of adequate data, it is hard to accurately capture the impact of decisions such as demonetisation. Even many noted economist raised eyebrows, believing that Q3FY17 data was too good to be true. And indeed, if we look at the Private Final Consumption Expenditure (PFCE) data (10.1%) vis-a-vis the Government Final Consumption Expenditure (GFCE) data (19.9%), it signals that private capex cycle is still fragile. Besides, the data of the cash dependent informal sector, that forms a huge part of the Indian economy, is going unreported as the GDP data does not encapsulate it.

However, GST going into effect from July 1, 2017 could potentially add 2.0-2.5% to country's economic growth.

The dwindling core sector growth (comprising of 8 industries: coal, crude oil, natural gas, refinery products, fertilizers, steel, cement, and electricity), that holds a 38% weightage on the Index of Industrial Production (IIP), is symptomatic that GDP data in the last quarter of the fiscal year 2016-17 and the ensuing few quarters may be under pressure. Core sector growth has slipped to over a 1-year low of 1% in February 2017 (data released in March) from 3.4% in the month before, mainly on decline in output of crude oil (by 3.4%), natural gas (by 1.7%), refinery products (by 2.3%), fertilisers (by 5.3%) and cement (by 15.8%). This is the lowest core sector growth since August 2016, and is likely to have a bearing on the IIP.

The IIP data for February 2017 (released in April) has already contracted to -1.2% (a 4-month low) from +3.27% reported in the previous month. The decline is mainly on account of the negative 2% growth reported by the manufacturing sector constituting over 75% of the index. The capital goods has reported a decline (-3.4%) too, and so has consumer goods and non-consumer goods by -5.6% and -8.6% respectively. Overall, 15 out of 22 industry groups in the manufacturing sector showed negative growth in February.

Retail inflation data for March 2017 (as measured by the Consumer Price Index) has inched-up to 3.81% from 3.65% in the previous month, ignited by higher fuel inflation (5.65% in March), while food inflation reported a softer growth. However, the expected El-Nino effect around July-August 2017 could have a bearing on food prices, although the IMD (Indian Meteorological Department) forecasts a normal southwest monsoon this year.

Looking forward, once the GST regime comes into force, at least initially it entails a risk to inflation. So, the RBI has been right in projecting the inflation trajectory, and hence refrained from reducing policy rates. The change in monetary policy stance from 'accommodative' to 'neutral' by the central bank, enables the RBI to maintain status quo on policy rates for the short-to-medium. And if inflation continues to pop its ugly head, RBI may even increase policy rates in 2018.

The Indian rupee is displaying resilience; which has its pros and cons. While this'll reduce the import bill of the country, an appreciating rupee is a blow to certain export-oriented sectors viz. Information Technology, pharmaceuticals, consulting, etc. A continued rupee rally carries economic risks, given it could threaten a nascent recovery in exports, which account for nearly a fifth of India's economic output at a time when domestic demand remains weak.

Coming to corporate earnings, big IT companies such as Infosys and TCS have already disappointed Dalal Street with subdued numbers. Players in the IT sector are cautious as various sectors are facing multiple headwinds. Banks are encountering deterioration in quality of assets which points to a pocket of weakness. DCB Bank fell post their results announcements, while only a few banks - HDFC Bank and Yes Bank, have managed to meet street expectations. Consumer good players are worried about persistent weakness in the rural market and possible disruption during the GST regime. Some of the players are yet to recover from the shock of demonetisation. In cases such as ACC, the input costs have been denting operating profit margins due to higher power, fuel, freight and forwarding expenses. For real estate firms, they're grappling with high levels of unsold inventory as buyers are cautious despite lowered borrowing rates.

So broadly, corporate earnings so far have been mixed, and earnings will have to justify valuations if the market needs to move up from here on. If corporate earnings do not improve, investors may stop paying a higher price. Earnings failing to justify valuations, may not only weigh on the market, but also on corporate tax collections and investment cycle (due to a lag effect).

The Indian economy continues to remain coupled to the global backdrop. It may be marred with global political shocks stemming out of Brexit and the US President, Mr Donald Trump's economic policies. Political shocks like Trump or 'Brexit', point to a deeper structural shift - notably a populist backlash against globalisation and the perceived impact of these trends in increasing income inequality. These trends pose real policy challenges across the developed world and beyond.

The protectionist rhetoric from the White House, since President Trump took office, has rattled emerging economies dependent on capital from the United States. His rhetoric has signalled an emphasis on pro-growth and America-first during his presidency. Although policies such as increased infrastructure spending and tax cuts are expected to stimulate the US economy, the trade policies currently being touted may be detrimental for global growth, particularly for the emerging economies. However, after a backlash on his policies and ban-politics, the US President has softened his tone. This scenario has caused extreme uncertainty over the short-term. While there is flush of liquidity from the global front with an accommodative monetary stance taken by the central bankers of developed economies, a few factors that can alter the direction of the market are: Trumponomics, 'Brexit', elections in the Eurozone, the Eurozone's macroeconomic variables, China's macroeconomic variables, and geopolitical tensions.

So, the risk-return trade-off doesn't seem very comfortable in the short-to-medium term. It's pointless going gung-ho while everything may look hunky-dory on the surface.

"Risk control is invisible in good times but still essential, since good times can so easily turn onto bad times" - Howard Marks, American investor and writer

Even the world's best investors take account of the fact that some things cannot be known. Forecasts are often wrong. Investors make mistakes. Thus, in the interest of your long-term financial wellbeing, it's best that you wisely structure and review your portfolio.

How?

Primarily, pay heed to your asset allocation. Based on age, income & expenses, assets & liabilities, risk appetite, investment objectives, investment horizon and financial goals; define your asset allocation. Only if it directs you to invest in equities, take exposure to stock and mutual funds, and not because the next door neighbour or friends invests in it. Remember, each one's financial health, circumstances, investment objectives, investment horizon, risk appetite, financial goals, are different; and it's vital to take due cognisance of this while structuring and reviewing your portfolio, rather than just following the herd.

As the market has ascended, take some time to prudently review and rebalance your portfolio to ensure that you aren't grossly skewed to equities; and don't hold equity instrument - be it stocks or equity mutual funds - that can damage your long-term financial health.

If you've bought equity mutual funds in the past, influenced by the sweet talk of mutual fund distributors / agents / investment advisers / relationship managers, or bought stocks and funds based on tips from so-called experts on glamorous television business channels or pink papers, please prudently review your portfolio. Because for all you know, there could be some dud holdings in your portfolio, hindering the path to wealth creation. When you invest, remember it's your hard-earned money, and thus probing a little deeper can always be in the interest of yours and your family's long-term financial future.

If you've added too many stocks and mutual fund schemes, perhaps it's time to trim your portfolio. Note that, while diversification is good for your portfolio and is one of the basic tenets of investing, over-diversification tends to limit the return on your investments. Hence, you ought to be thoughtful while you structure and/or review your portfolio and substantiate it with thorough research. You see, with the right asset mix and proper diversification, you can optimise a strategic asset allocation portfolio to earn the greatest possible rate of return at a given level of risk.

Currently, in an overvalued market, going all out and investing in mid-and small-caps can prove to be an unintelligent move. You will most likely end up burning your fingers. Likewise, totally skewing your portfolio only to large-cap funds would mean possibly losing out on additional return potential, if the market scales up further from here on. You need to strike the correct risk-return trade-off.

PersonalFN therefore recommends that you follow a 'core and satellite approach' to investing. Here are 6 benefits of 'core and satellite approach':

Facilitates optimal diversification;

Reduces the risk to your portfolio;

Enables you to benefit from a variety of investment strategies;

Aims to create wealth cushioning the downside;

Offers the potential to outperform the market; and

Reduces the need for constant churning of your entire portfolio

'Core and satellite' investing is a time-tested strategic way to structure and/or restructure your investment portfolio. Your 'core portfolio' should consist of large-cap, multi-cap, and value style funds, while the 'satellite portfolio' should include funds from the mid-and-small cap category and opportunities style funds.

But what matters the most is the art of astutely structuring the portfolio by assigning weightages to each category of mutual funds and the schemes you select for the portfolio.

Moreover, with change in market outlook the allocation/weightage to each of the schemes, especially in the satellite portfolio, need to change.

Keep in mind: Constructing a portfolio with a stable core of long-term investments and a periphery of more specialist or shorter-term holdings can help to deliver the benefits of asset allocation and offer the potential to outperform the market. The satellite portfolio provides the opportunity to support the core by taking active calls determined by extensive research.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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